Virtually every portfolio manager claims to invest in a risk-controlled manner. However, investors looking at their monthly statements during the credit crisis of 2007-08 were probably wondering what happened to those risk controls as their wealth plummeted.

How were these losses possible? If both the top-down, portfolio-builders and the bottom-up, stock-picking money managers were all focused on risk, how did investors manage to lose so much money in such a short period of time?

One explanation is that there are different ways to think of and define risk.

MVO Portfolio Construction

Many portfolios were constructed using mean-variance optimization (MVO), a strategy that seeks to minimize the volatility of an overall portfolio by diversifying across uncorrelated asset classes.

At this top-down level, risk is defined as volatility, or how much an investment deviates from its long-term average. The very technique used in the creation of many portfolios- mean-variance optimization — reveals the objective of the strategy. MVO optimizes the return-versus-volatility trade-off.

Once the overall portfolio strategy was set, the job of actually investing was often implemented by a collection of active managers.

Active managers often have a different definition of risk.

For many active managers risk is measured against a passive market benchmark, such as the S&P 500 or the Russell 2000. Positions are taken to over- or underweight an aspect of a benchmark.

Success is measured in terms of benchmark metrics – for example, relative metrics like alpha or information ratio. Insights are gleaned via attribution analysis quantifying the sector or stock picks that helped or hurt relative performance.